The Shifting Sands of the MBS Market: Will Fannie and Freddie Reclaim Their Influence?
For decades, Fannie Mae and Freddie Mac weren’t just players in the US mortgage market – they were the market. Before the 2008 financial crisis, their hedging activities and massive portfolios dictated much of the flow. Now, with a $200 billion directive from former President Trump, questions are swirling about whether the government-sponsored enterprises (GSEs) will once again become dominant forces and what that means for interest rates and market volatility.
A History of Market Dominance
Prior to the financial crisis, Fannie and Freddie held over $1 trillion in mortgage-backed securities (MBS), roughly a third of the entire market. They didn’t just buy mortgages to free up bank balance sheets; they actively managed risk, using interest rate derivatives and Treasuries to minimize mismatches between their assets and liabilities. This “duration gap” – the difference between the lifespan of their mortgage holdings and their debts – was, according to Harley Bassman of Simplify Asset Management, “the biggest number in the market.”
The Post-Crisis Landscape
Following the government takeover in the wake of the 2008 crisis, the GSEs significantly reduced their MBS holdings. This created space for banks and the Federal Reserve to step in as major buyers. However, neither the Fed nor commercial banks hedged their portfolios with the same intensity as Fannie and Freddie once did, effectively eliminating the MBS buying-rates hedging cycle.
Trump’s Directive and Current Impact
The recent instruction to purchase $200 billion in MBS raised eyebrows, prompting speculation about a potential resurgence in the GSEs’ market influence. However, experts like Walt Schmidt of FHN Financial believe the impact will be limited. “They’ll take out 100% of net supply,” Schmidt noted, “but I don’t consider it’s really going to have any impact on the Treasury market.”
As of December, the GSEs’ combined portfolio totaled $272 billion, up 52% from May, suggesting they may have already been increasing purchases prior to the directive. This figure, while the largest in years, still only represents 3% of the outstanding market, compared to the Fed’s over $2 trillion and commercial banks’ $2.7 trillion.
The Duration Gap and Potential for Volatility
Fannie and Freddie’s historical influence stemmed from their active management of negative convexity – the tendency for mortgage bond duration to decline as rates fall due to refinancing. They would hedge this risk by issuing callable debt and using derivatives. This process, while effective, created a cyclical pattern of buying and selling that contributed to market volatility.
“They’d buy mortgage bonds. They would then short Treasuries, short futures, and pay fixed on swaps to offset the duration,” explains Bassman. “That’s how you got large volatility in those years.”
Today, with many homeowners holding mortgages at rates significantly below current levels, the risk of widespread refinancing is lower. However, as more mortgages are issued at higher rates, this exposure will increase.
Strategists at Deutsche Bank suggest that any increase in GSE holdings and hedging activity could widen swap spreads, as they would likely pay fixed in SOFR swaps to hedge their duration mismatch.
Will the GSEs Change the Game Again?
While a full return to the pre-crisis era seems unlikely, the GSEs’ increased activity could introduce a familiar dynamic to the rates market. The key will be whether they choose to actively hedge their portfolios, and to what extent. Even a modest increase in hedging could lead to a slight uptick in implied volatility, though separating this effect from broader macroeconomic factors may prove difficult.
Did you understand?
The Federal Reserve held more than $2 trillion in MBS at the complete of December, while commercial banks held $2.7 trillion. Together, they represent roughly half of the entire MBS market.
Pro Tip
Keep a close eye on the FHFA’s announcements and filings for updates on the GSEs’ MBS holdings and hedging strategies. These will provide valuable insights into their evolving role in the market.
FAQ
Q: Will the GSEs’ purchases lower mortgage rates?
A: Experts suggest the impact on mortgage rates will be limited, as the $200 billion purchase represents a significant portion of net supply but is unlikely to significantly affect the broader Treasury market.
Q: What is a duration gap?
A: A duration gap is the difference between the lifespan of a financial institution’s assets (like mortgages) and its liabilities (like debts). Managing this gap is crucial for mitigating interest rate risk.
Q: What is negative convexity?
A: Negative convexity refers to the relationship where bond duration and rates move together. Falling rates increase the likelihood of refinancing, shortening the duration of MBS.
Q: What is SOFR?
A: SOFR stands for Secured Overnight Financing Rate. It is a benchmark interest rate used in financial markets.
Wish to learn more about the mortgage-backed securities market? Explore Investopedia’s guide to MBS.
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